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Prepared by

Coby Harmon
University of California, Santa Barbara
Westmont College

26-1
26 Incremental Analysis and
Capital Budgeting
Learning Objectives
After studying this chapter, you should be able to:
[1] Identify the steps in managements decision-making process.
[2] Describe the concept of incremental analysis.
[3] Identify the relevant costs in accepting an order at a special price.
[4] Identify the relevant costs in a make-or-buy decision.
[5] Identify the relevant costs in determining whether to sell or process materials further.
[6] Identify the relevant costs to be considered in repairing, retaining, or replacing
equipment.
[7] Identify the relevant costs in deciding whether to eliminate an unprofitable segment
or product.
[8] Determine which products to make and sell when resources are limited.
[9] Contrast annual rate of return and cash payback in capital budgeting.
[10] Distinguish between the net present value and internal rate of return methods.
26-2
Preview of Chapter 26

Accounting Principles
Eleventh Edition
Weygandt Kimmel Kieso
26-3
Incremental Analysis

Managements Decision-Making Process


Making decisions is an important management function.
Does not always follow a set pattern.
Decisions vary in scope, urgency, and importance.
Steps usually involved in process include:
Illustration 26-1

26-4 LO 1 Identify the steps in managements decision-making process.


Incremental Analysis

In making business decisions,


Considers both financial and non-financial information.
Financial information
Revenues and costs, and
Effect on overall profitability.

Non-financial information
Effect on employee turnover
The environment
Overall company image.

26-5 LO 1 Identify the steps in managements decision-making process.


Incremental Analysis

Incremental Analysis Approach


Decisions involve a choice among alternative actions.

Process used to identify the financial data that change


under alternative courses of action.
Both costs and revenues may vary or

Only revenues may vary or

Only costs may vary

26-6 LO 2 Describe the concept of incremental analysis.


Incremental Analysis

How Incremental Analysis Works


Illustration 26-2

Incremental revenue is $15,000 less under Alternative B.


Incremental cost savings of $20,000 is realized.
Alternative B produces $5,000 more net income.

26-7 LO 2 Describe the concept of incremental analysis.


Incremental Analysis

How Incremental Analysis Works


Important concepts used in incremental analysis:
Relevant cost.

Opportunity cost.

Sunk cost.

26-8 LO 2 Describe the concept of incremental analysis.


Incremental Analysis

How Incremental Analysis Works


Sometimes involves changes that seem contrary to
intuition.

Variable costs sometimes do not change under


alternatives.

Fixed costs sometimes change between alternatives.

26-9 LO 2 Describe the concept of incremental analysis.


Incremental Analysis

Common types of decisions involving incremental analysis:


1. Accept an order at a special price.

2. Make or buy component parts or finished products.

3. Sell or process further them further

4. Repair, retain, or replace equipment.

5. Eliminate an unprofitable business segment or product.

26-10 LO 2 Describe the concept of incremental analysis.


Incremental Analysis

Question
Incremental analysis is the process of identifying the financial
data that

a. Do not change under alternative courses of action.

b. Change under alternative courses of action.

c. Are mixed under alternative courses of action.

d. None of the above.

26-11 LO 2 Describe the concept of incremental analysis.


26-12
Incremental Analysis

Accept an Order at a Special Price


Obtain additional business by making a major price
concession to a specific customer.

Assumes that sales of products in other markets are


not affected by special order.

Assumes that company is not operating at full capacity.

26-13 LO 3 Identify the relevant costs in accepting an order at a special price.


Incremental Analysis

Accept an Order at a Special Price


Illustration: Sunbelt Company produces 100,000 Smoothie blenders
per month, which is 80% of plant capacity. Variable manufacturing
costs are $8 per unit. Fixed manufacturing costs are $400,000, or $4
per unit. The blenders are normally sold directly to retailers at $20
each. Sunbelt has an offer from Kensington Co. (a foreign wholesaler)
to purchase an additional 2,000 blenders at $11 per unit. Acceptance
of the offer would not affect normal sales of the product, and the
additional units can be manufactured without increasing plant
capacity. What should management do?

26-14 LO 3 Identify the relevant costs in accepting an order at a special price.


Incremental Analysis

Accept an Order at a Special Price


Illustration 26-4

Fixed costs do not change since within existing capacity thus


fixed costs are not relevant.

Variable manufacturing costs and expected revenues change


thus both are relevant to the decision.

Advance slide in presentation mode to reveal answer.


26-15 LO 3
26-16
> DO IT!
Cobb Company incurs costs of $28 per unit ($18 variable and $10
fixed) to make a product that normally sells for $42. A foreign
wholesaler offers to buy 5,000 units at $25 each. Cobb will incur
additional shipping costs of $1 per unit. Compute the increase or
decrease in net income Cobb will realize by accepting the special
order, assuming Cobb has excess operating capacity. Should Cobb
Company accept the special order?

Accept
or
Reject?

26-17 Advance slide in presentation mode to reveal answer. LO 3


Incremental Analysis

Make or Buy
Illustration: Baron Company incurs the following annual costs in
producing 25,000 ignition switches for motor scooters.

Illustration 26-5

Instead of making its own switches, Baron Company might purchase


the ignition switches at a price of $8 per unit. What should
management do?

26-18 LO 4 Identify the relevant costs in a make-or-buy decision.


Incremental Analysis

Make or Buy
Illustration 26-6

Total manufacturing cost is $1 higher per unit than purchase price.

Must absorb at least $50,000 of fixed costs under either option.

Advance slide in
presentation mode to
26-19 reveal answer. LO 4 Identify the relevant costs in a make-or-buy decision.
Incremental Analysis

Make or Buy Opportunity Cost


The potential benefit that
may be obtained from
following an alternative
course of action.

26-20 LO 4 Identify the relevant costs in a make-or-buy decision.


Incremental Analysis

Make or Buy Opportunity Cost


Illustration: Assume that through buying the switches, Baron
Company can use the released productive capacity to generate
additional income of $38,000 from producing a different product.
This lost income is an additional cost of continuing to make the
switches in the make-or-buy decision.
Illustration 26-7

Advance slide in
presentation mode to
26-21 reveal answer. LO 4 Identify the relevant costs in a make-or-buy decision.
Incremental Analysis

Question
In a make-or-buy decision, relevant costs are:

a. Manufacturing costs that will be saved.

b. The purchase price of the units.

c. Opportunity costs.

d. All of the above.

26-22 LO 4 Identify the relevant costs in a make-or-buy decision.


> DO IT!
Juanita Company must decide whether to make or buy some of its
components for the appliances it produces. The costs of producing
166,000 electrical cords for its appliances are as follows.
Direct materials $90,000 Variable overhead $32,000
Direct labor 20,000 Fixed overhead 24,000
Instead of making the electrical cords at an average cost per unit of
$1.00 ($166,000 166,000), the company has an opportunity to buy the
cords at $0.90 per unit. If the company purchases the cords, all variable
costs and one-fourth of the fixed costs will be eliminated.
(a) Prepare an incremental analysis showing whether the company
should make or buy the electrical cords. (b) Will your answer be different
if the released productive capacity will generate additional income of
$5,000?

26-23 LO 4 Identify the relevant costs in a make-or-buy decision.


> DO IT!
(a) Prepare an incremental analysis showing whether the company
should make or buy the electrical cords.

Juanita Company will incur $1,400 of additional costs if it buys the


electrical cords rather than making them.
Advance slide in
presentation mode to
26-24 reveal answer. LO 4 Identify the relevant costs in a make-or-buy decision.
> DO IT!
(b) Will your answer be different if the released productive capacity
will generate additional income of $5,000?

Yes, net income will be increased by $3,600 if Juanita Company


purchases the electrical cords rather than making them.

Advance slide in
presentation mode to
26-25 reveal answer. LO 4 Identify the relevant costs in a make-or-buy decision.
Incremental Analysis

Sell or Process Further


May have option to sell product at a given point in
production or to process further and sell at a higher
price.
Decision Rule:

Process further as long as the incremental revenue from


such processing exceeds the incremental processing
costs.

LO 5 Identify the relevant costs in determining whether


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to sell or process materials further.
Incremental Analysis

Sell or Process Further


Illustration: Woodmasters Inc. makes tables. The cost to
manufacture an unfinished table is $35. The selling price per
unfinished unit is $50.Illustration 26-8 Woodmasters has
unused capacity that can be used to finish
the tables and sell them at $60 per unit. For a finished table, direct
materials will increase $2 and direct labor costs will increase $4.
Variable manufacturing overhead costs will increase by $2.40 (60%
of direct labor). No increase is anticipated in fixed manufacturing
overhead.

LO 5 Identify the relevant costs in determining whether


26-27
to sell or process materials further.
Incremental Analysis

Sell or Process Further


The incremental analysis on a per unit basis is as follows.
Illustration 26-9

Should Woodmasters sell or process


processfurther?
further.

26-28 Advance slide in presentation mode to reveal answer. LO 5


Incremental Analysis

Question
The decision rule is a sell-or-process-further decision:
Process further as long as the incremental revenue from
processing exceeds:

a. Incremental processing costs.

b. Variable processing costs.

c. Fixed processing costs.

d. No correct answer is given.

LO 5 Identify the relevant costs in determining whether


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to sell or process materials further.
Incremental Analysis

Repair, Retain, or Replace Equipment


Illustration: Jeffcoat Company is considering replacing a factory
machine with a new machine. Jeffcoat Company has a factory
machine that originally cost $110,000. It has a balance in
Accumulated Depreciation of $70,000, so its book value is $40,000. It
has a remaining useful life of four years. The company is considering
replacing this machine with a new machine. A new machine is
available that costs $120,000. It is expected to have zero salvage
value at the end of its four-year useful life. If the new machine is
acquired, variable manufacturing costs are expected to decrease from
$160,000 to $125,000 and the old unit could be sold for $5,000. The
incremental analysis for the four-year period is as follows.

LO 6 Identify the relevant costs to be considered in


26-30
repairing, retaining, or replacing equipment.
Incremental Analysis

Repair, Retain, or Replace Equipment


Prepare the incremental analysis for the four-year period.
Illustration 26-10

Retain or Replace?

LO 6 Identify the relevant costs to be considered in


26-31
repairing, retaining, or replacing equipment.
Incremental Analysis

Repair, Retain, or Replace Equipment


Additional Considerations
The book value of old machine does not affect the decision.
Book value is a sunk cost.
Costs which cannot be changed by future decisions (sunk
cost) are not relevant in incremental analysis.
However, any trade-in allowance or cash disposal value of
the existing asset is relevant.

LO 6 Identify the relevant costs to be considered in


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repairing, retaining, or replacing equipment.
Incremental Analysis

Eliminate an Unprofitable Segment or Product


Key: Focus on Relevant Costs.
Consider effect on related product lines.
Fixed costs allocated to the unprofitable segment must be
absorbed by the other segments.
Net income may decrease when an unprofitable segment
is eliminated.
Decision Rule: Retain the segment unless fixed costs
eliminated exceed contribution margin lost.

LO 7 Identify the relevant costs in deciding whether to


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eliminate an unprofitable segment or product.
Incremental Analysis

Eliminate an Unprofitable Segment or Product


Illustration: Venus Company manufactures three models of tennis
rackets:
Profitable lines: Pro and Master Should Champ
be eliminated?
Unprofitable line: Champ
Illustration 26-11

LO 7 Identify the relevant costs in deciding whether to


26-34
eliminate an unprofitable segment or product.
Incremental Analysis

Eliminate an Unprofitable Segment or Product


Prepare income data after eliminating Champ product line. Assume
fixed costs are allocated 2/3 to Pro and 1/3 to Master.

Illustration 26-12

Total income is decreased by $10,000.

26-35 LO 7
Incremental Analysis

Eliminate an Unprofitable Segment or Product


Incremental analysis of Champ provided the same results:

Do Not Eliminate Champ


Illustration 26-13

LO 7 Identify the relevant costs in deciding whether to


26-36
eliminate an unprofitable segment or product.
Incremental Analysis

Question
If an unprofitable segment is eliminated:
a. Net income will always increase.
b. Variable expenses of the eliminated segment will have
to be absorbed by other segments.
c. Fixed expenses allocated to the eliminated segment will
have to be absorbed by other segments.
d. Net income will always decrease.

LO 7 Identify the relevant costs in deciding whether to


26-37
eliminate an unprofitable segment or product.
> DO IT!
Lambert, Inc. manufactures several types of accessories. For the
year, the knit hats and scarves line had sales of $400,000, variable
expenses of $310,000, and fixed expenses of $120,000. Therefore,
the knit hats and scarves line had a net loss of $30,000. If Lambert
eliminates the knit hats and scarves line, $20,000 of fixed costs will
remain. Prepare an analysis showing whether the company should
eliminate the knit hats and scarves line.

26-38 Advance slide in presentation mode to reveal answer. LO 7


26-39
Incremental Analysis

Allocate Limited Resources


Resources are always limited.
Floor space for a retail firm.
Raw materials, direct labor hours, or machine capacity
for a manufacturing firm.
Management must decide which products to make and
sell to maximize net income.

26-40 LO 8 Determine which products to make and sell when resources are limited.
Incremental Analysis

Allocate Limited Resources


Illustration: Collins Company manufactures deluxe and standard
pen and pencil sets. The limiting resource is machine capacity,
which is 3,600 hours per month. Relevant data consist of the
following.
Illustration 26-14
Contribution margin and
machine hours

Compute contribution margin per unit of limited resource.

26-41 LO 8 Determine which products to make and sell when resources are limited.
Incremental Analysis

Allocate Limited Resources


Compute contribution margin per unit of limited resource.

Illustration 26-15

Company should shift the sales mix to standard sets or should


increase machine capacity.

26-42 LO 8 Determine which products to make and sell when resources are limited.
Incremental Analysis

Allocate Limited Resources


Illustration: Assume Collins is able to increase machine capacity
from 3,600 hours to 4,200 hours, the additional 600 hours could be
used to produce either the standard or deluxe pen and pencil sets.
Determine the total contribution margin under each alternative.

Illustration 26-16

26-43 LO 8 Determine which products to make and sell when resources are limited.
Capital Budgeting

Capital Budgeting is the process of making capital


expenditure decisions in business.

Amount of possible capital expenditures usually exceeds


the funds available for such expenditures.

Involves choosing among various capital projects to find


the one(s) that will maximize a companys return on
investment.

26-44 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Capital Budgeting

Evaluation Process
Many companies follow a carefully prescribed process in
capital budgeting. Illustration 26-17
Corporate capital budget
authorization process

26-45 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Evaluation Process

Providing management with relevant data for capital


budgeting decisions requires familiarity with quantitative
techniques.
Most common techniques are:
1. Annual Rate of Return

2. Cash Payback

3. Discounted Cash Flow

26-46 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
26-47
Capital Budgeting

Annual Rate of Return


Indicates the profitability of a capital expenditure by dividing
expected annual net income by the average investment.

Illustration 26-19

26-48 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Annual Rate of Return
Illustration: Reno Company is considering an investment of
$130,000 in new equipment. The new equipment is expected to
last 5 years. It will have zero salvage value at the end of its useful
life. Reno uses the straight-line method of depreciation for
accounting purposes. The expected annual revenues and costs of
the new product that will be produced from the investment are:
Illustration 26-18

26-49 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Annual Rate of Return

Computing Average Investment Illustration 26-20


Formula for computing
average investment

130,000 + 0
= $65,000
2

Expected annual $13,000


= 20%
rate of return $65,000

A project is acceptable if its rate of return is greater than


managements required rate of return.

26-50 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Annual Rate of Return

Principal advantages:

Simplicity of calculation.

Managements familiarity with the accounting terms used in


the computation.

Major limitation:

Does not consider the


time value of money.

26-51 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
> DO IT!
Watertown Paper Corporation is considering adding another machine for the
manufacture of corrugated cardboard. The machine would cost $900,000. It
would have an estimated life of 6 years and no salvage value. The company
estimates that annual revenue would increase by $400,000 and that annual
expenses excluding depreciation would increase by $190,000. It uses the
straight-line method to compute depreciation expense. Management has a
required rate of return of 9%. Compute the annual rate of return.

26-52 Advance slide in presentation mode to reveal answer. LO 9


Cash Payback
Cash payback technique identifies the time period required
to recover the cost of the capital investment from the net
annual cash inflow produced by the investment.

Illustration 26-22
Computation of net annual
cash flow

Illustration 26-21
Cash payback formula

$130,000 $39,000 = 3.3 years

26-53 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Cash Payback

The shorter the payback period, the more attractive the


investment.

In the case of uneven net annual cash flows, the company


determines the cash payback period when the cumulative net
cash flows from the investment equal the cost of the
investment.

26-54 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Cash Payback

Illustration: Chen Company proposes an investment in a new


website that is estimated to cost $300,000.
Illustration 26-23
Net annual cash flow
schedule

Cash payback should not be the only basis for capital budgeting
decision as it ignores expected profitability of the project.

26-55 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
26-56
> DO IT!

Watertown Paper Corporation is considering adding another machine


for the manufacture of corrugated cardboard. The machine would
cost $900,000. It would have an estimated life of 6 years and no
salvage value. The company estimates that annual cash inflows
would increase by $400,000 and that annual cash outflows would
increase by $190,000. Compute the cash payback period.

26-57 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Cash Payback

Question
A $100,000 investment with a zero scrap value has an 8-year
life. Compute the payback period if straight-line depreciation
is used and net income is determined to be $20,000.

a. 8.00 years.

b. 3.08 years.

c. 5.00 years.

d. 13.33 years.

26-58 LO 9 Contrast annual rate of return and cash payback in capital budgeting.
Discounted Cash Flow

Discounted Cash Flow


Generally recognized as the best conceptual approach.
Considers both the estimated total net cash flows from
the investment and the time value of money.
Two methods:
Net present value.
Internal rate of return.

LO 10 Distinguish between the net present value


26-59
and internal rate of return methods.
Discounted Cash Flow

Net Present Value Method


Net cash flows are discounted to their present value and
then compared with the capital outlay required by the
investment.
Interest rate used in discounting is the required minimum
rate of return.
Proposal is acceptable when NPV is zero or positive.
The higher the positive NPV, the more attractive the
investment.

LO 10 Distinguish between the net present value


26-60
and internal rate of return methods.
Discounted Cash Flow

Illustration 26-24
A proposal is Net present value decision
criteria
acceptable when net
present value is zero
or positive.

26-61 LO 10
Discounted Cash Flow

Equal Net Annual Cash Flows


Illustration: Reno Companys net annual cash flows are $39,000.
If we assume this amount is uniform over the assets useful life,
we can compute the present value of the net annual cash flows.

Illustration 26-25

Calculate the net present value.

LO 10 Distinguish between the net present value


26-62
and internal rate of return methods.
Discounted Cash Flow

Equal Net Annual Cash Flows


Illustration: Calculate the net present value.
Illustration 26-26

The proposed capital expenditure is acceptable at a required rate


of return of 12% because the net present value is positive.

LO 10 Distinguish between the net present value


26-63
and internal rate of return methods.
Discounted Cash Flow

Unequal Net Annual Cash Flows


Illustration: Reno Company management expects the same
aggregate net annual cash flow ($195,000) over the life of the
investment. But because of a declining market demand for the
new product over the life of the equipment, the net annual cash
flows are higher in the early years and lower in the later years.

LO 10 Distinguish between the net present value


26-64
and internal rate of return methods.
Discounted Cash Flow

Unequal Net Annual Cash Flows Illustration 26-27


Computing present value of
unequal annual cash flows

LO 10 Distinguish between the net present value


26-65
and internal rate of return methods.
Discounted Cash Flow

Unequal Net Annual Cash Flows


Illustration: Calculate the net present value. Illustration 26-28
Analysis of proposal using net
present value method

The proposed capital expenditure is acceptable at a required rate


of return of 12% because the net present value is positive.

LO 10 Distinguish between the net present value


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and internal rate of return methods.
26-67
Discounted Cash Flow

Internal Rate of Return Method


IRR method finds the interest yield of the potential
investment.
IRR is the rate that will cause the PV of the proposed
capital expenditure to equal the PV of the expected
annual cash inflows.
Two steps in method:
Compute the interval rate of return factor.
Use the factor and the PV of an annuity of 1 table to find
the IRR.

LO 10 Distinguish between the net present value


26-68
and internal rate of return methods.
Discounted Cash Flow

Internal Rate of Return Method


Step 1. Compute the internal rate of return factor.
Illustration 26-29

For Reno Company:

$130,000 $39,000 = 3.3333

LO 10 Distinguish between the net present value


26-69
and internal rate of return methods.
Discounted Cash Flow

Internal Rate of Return Method


Step 2. Use the factor and the present value of an annuity
of 1 table to find the internal rate of return.

Assume a required rate of return for Reno of 10%.

Decision Rule: Accept the project when the IRR is equal to or


greater than the required rate of return.

LO 10 Distinguish between the net present value


26-70
and internal rate of return methods.
Internal Rate of Return Method

Illustration 26-30

LO 10 Distinguish between the net present value


26-71
and internal rate of return methods.
Discounted Cash Flow

Comparing Discounted Cash Flow Methods


Illustration 26-31

LO 10 Distinguish between the net present value


26-72
and internal rate of return methods.
Discounted Cash Flow

Question
A positive net present value means that the:

a. Projects rate of return is less than the cutoff rate.

b. Projects rate of return exceeds the required rate of


return.

c. Projects rate of return equals the required rate of


return.

d. Project is unacceptable.

LO 10 Distinguish between the net present value


26-73
and internal rate of return methods.
> DO IT!
Watertown Paper Corporation is considering adding another machine
for the manufacture of corrugated cardboard. The machine would cost
$900,000. It would have an estimated life of 6 years and no salvage
value. The company estimates that annual revenues would increase
by $400,000 and that annual expenses excluding depreciation would
increase by $190,000. Management has a required rate of return of
9%.

(a) Calculate the net present value on this project.

(b) Calculate the internal rate of return on this project, and


discuss whether it should be accepted.

LO 10 Distinguish between the net present value


26-74
and internal rate of return methods.
> DO IT!
(a) Calculate the net present value on this project.

Watertown should accept the project.

LO 10 Distinguish between the net present value


26-75
and internal rate of return methods.
> DO IT!
(b) Calculate the internal rate of return on this project, and discuss
whether it should be accepted.

$900,000 210,000 = 4.285714.

Since the project has an internal rate that is greater than 10% and the
required rate of return is only 9%, Watertown should accept the project.
26-76 LO 10
Copyright

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26-77